On Transaction Costs

William Coates provides a merchant’s veiw of Bitcoin. Here are a few points he makes on transaction costs:

Transaction fees are fairly horrible with traditional payment providers, especially when it comes to smaller transactions, as there is often a minimum fee.

With bitcoin, transaction fees are entirely optional. The currency’s protocol allows you to set the transaction fee to zero if you so wish, however this might mean it takes a bit longer to process.

The idea behind bitcoin transaction fees is that the computers running the network (in an entirely distributed manner) get to keep the transaction fees associated with the transactions they have successfully processed.

It’s quite likely that, in the future, we will see the fees be determined by the market, and if you want your transaction processed as fast as possible, you will have to pay a premium. Currently, transaction fees are not the primary motivation for people to run the network, but that’s an entirely other topic. A useful graph showing the fees charged by the entire network over time can be viewed here.

Coates goes on further to point out that when using the Paypal payment system, transaction fees can range from roughly 3-30%, with the highest fees on the smallest transactions. Using the Bitcoin based payment system BitPay, Coates reports that transaction fees are close to 1%. This presumably results in lower operating costs for his business that can be passed on to the customer.

That’s great. However, the numbers put forward by Coates are merely “transaction fees,” which represent only one component of the total “transaction costs” of an exchange. Thanks to Ronald Coase, we now recognize that transaction costs include a broad spectrum of costs incurred in making an exchange. Transaction fees are just one such cost.

I suspect that early adopters of Bitcoin are focusing on its “transaction fee” advantage simply because that is one of the most visible components of the broader “transaction cost” of exchange. This is likely because transaction fees have a tangible value that can be seen with each transaction.

It is nice to hear that Bitcoin has lowered transactions fees for this particular merchant. Bitcoin advocates hold high hopes that Bitcoin will do the same for many more merchants. However, it should be pointed out that transaction fees are merely one facet of transaction costs. For me, many exciting questions remain as to how advances in digital payment systems might be able to reduce transaction costs beyond just the most visible and tangible that have been identified by Coates and other Bitcoin early adopters.

Consider a more intangible and less visible transaction cost: counter-party trust. Most incumbent digital payment systems require a high level of trust among parties. With credit cards for example, the buyer must entrust the seller to run the transaction. This requires the buyer to share with the seller the information needed (e.g. name, credit card number) to process the transaction - the buyer is essentially granting the seller access to his/her account. For the buyer, sharing this information exposes them to the risk that a third party with malicious intent could gain access to this information and use it fraudulently. Once the seller gain access to the necessary information, they submit it to a third party (e.g. Visa) who processes the transaction. On their end, the seller bears the risk that the buyer has provided fraudulent information. Each one of these risks increases the cost of the transaction. Despite that fact that some payment systems, such as credit cards, protect the individual buyer from these risks, the risks still result in an added cost to the buyer. It just so happens that the cost is usually applied in aggregate, making it less tangible to the individual buyer. In some cases, as Coates points out, the seller passes these costs on directly to the buyer.

Bitcoin is allegedly a trust-less digital payment system, meaning that payments can be processed without the need for counter-party trust. With Bitcoin, the buyer can initiate the payment directly, without having to share access to their account with the seller or other third party. In this way, Bitcoin eliminates the risk of counter-party trust for payments and therefore reduces transaction costs beyond existing digital payment systems. Reduced transaction costs should theoretically enable new types of exchanges to occur. Digital tipping is an example of one such exchange that seems to have been enabled as a result of reduced transaction costs.

However, as discussed above with transaction fees, counter-party payment trust is just another component of the broader transaction cost. Nonetheless, Bitcoin represents a significant gain in reducing transaction costs for exchanges occuring in the digital world.

Despite such gains, Bitcoin is certainly not a panacea of digital payments. There is still much work to be done on this front. Another transaction cost associated with counter-party trust is the risk that the seller could fail to fulfill their side of the contract after the buyer’s payment has been processed. Perhaps Bitcoin can reduce this cost too. As the Bitcoin protocol develops further, or newer digital payment systems emerge, what other transaction costs can be reduced or eliminated? Additionally, does Bitcoin introduce any new transaction costs?